The Low-Interest-Rate Trap

Pretend for a second that you recently retired with a decent amount of money in the bank, and all you have to do is generate a paltry 5% to live in comfort for the rest of your days. But lately that’s been easier said than done. Your money market fund yields less than 1%. Your bond funds are around 3% and your bank CDs are are down to half the rate of a couple of years ago. Stocks, meanwhile, are down over the past decade and way too volatile in any event. If you don’t find a way to generate that 5% you’ll have to start eating into capital, which screws up your plan, possibly leaving you with more life than money a decade hence.

Now pretend that you’re running a multi-billion dollar pension fund. You’ve promised the trustees a 7% return and they’ve calibrated contributions and payouts accordingly. But nothing in the investment-grade realm gets you anywhere near 7%. If you come up short, the plan’s recipients won’t get paid in a decade or – the ultimate horror – you’ll have to ask the folks paying in to contribute more, which means you’ll probably be scapegoated out of a job.

In either case, what do you do? Apparently you start buying junk bonds. According to Saturday’s Wall Street Journal, junk issuance is soaring as desperate investors snap up whatever paper promises to get them the yield they’ve come to depend on. Here’s an excerpt:

The borrowing binge comes as the Federal Reserve keeps interest rates near zero and yields on U.S. government debt are near record lows. Those low rates have spread across a variety of markets, making it cheaper for companies with low credit ratings to borrow from investors.

Corporate borrowers with less than investment-grade ratings sold $15.4 billion in junk bonds this week, a record total for a single week, according to data provider Dealogic. The month-to-date total, $21.1 billion, is especially high for August, typically a quiet month that has seen an average of just $6.5 billion in issuance over the past decade.

For the year, the volume of U.S. junk bonds has exceeded $155 billion, 80% higher than in the year-ago period and easily on pace to surpass the record $163.6 billion total for 2009.

Investors have been snapping up the new non-investment-grade bonds, having grown frustrated with stocks and with the meager yields on safer government and high-grade corporate bonds.

“Even though high-yield bond yields have come [down], versus other asset classes, they’re still comparatively attractive, especially when you consider the direction of default today,” says Darin Schmalz, a director in leveraged finance at Fitch Ratings. “When you take into account other investment options for investors, and a benign default rate, the high-yield asset class is still pretty attractive.”

When the Fed keeps borrowing rates so low, “you see investors piling more into the high-yield market,” he says. “It becomes part of a virtuous cycle that allows lower-rated companies to refinance their liabilities.”

Companies are using most of the proceeds of the junk-bond offerings to refinance more expensive debt, or in some cases to pay special dividends to their private-equity owners. Many of the refinancings are for companies that took on massive debt over the last decade.

The refinancings, on the whole, are positive for the economy, because they help companies with too much debt avoid default or bankruptcy. But they do little to create new economic growth, and in some cases simply delay an inevitable reckoning.

Some thoughts:

This is exactly what the government is hoping for in pushing yields down to zero. Forcing conservative investors to reach for yield saves the day in the short run by funneling extra liquidity to the sector of the economy that is most in danger of imploding. So the military industrial complex/welfare state lives to borrow and spend another day.

One of the signs that a system headed for a crack-up is deteriorating credit quality. In other words, when low-quality entities are doing most of the borrowing, trouble will ensue. For more on this, look into the work of Hyman Minsky, an economist who seems to have understood today’s world pretty well.

This quote deserves a closer look: “When you take into account other investment options for investors, and a benign default rate, the high-yield asset class is still pretty attractive.” The only possible response to this is that they really should make a financial history course mandatory for money managers. The fact is that in every bubble, default rates are nice and low when capital is flowing in and then spike when the money stops. Jeeze, it was just a few years ago that housing analysts were using the low default rate on mortgages and credit cards to dismiss the possibility of a housing bust.

Obviously we’re once again solving a near-term problem by creating a much bigger one a few years down the road. What happens to retirees when their savings and pension funds are vaporized by the inevitable junk bond bust? More than likely they’ll panic and go to all cash, which will 1) crash the stock and bond markets, 2) leave them without enough income to meet their obligations, and 3) provoke another massive bailout at taxpayer expense. That is, unless the dollar tanks in the meantime, in which case it’s game over for everyone.

short term solutions end at the “minsky moment”….. There seems to be a trend to only look at the monthly interest income rather than the entire principal evaporation risk, this is flirting with financial disaster and indigence for the retired. This convenient myopia works in reverse too, people justtend to look at “the payment” not the total debt of a purchase…even our Govt just borrows until the interest begins to become uncomfortably large. but Minsky lurks there too… WE are one failded bond auction from disaster, when the massive debt must be rolled over and the interest doubles or triples and all of a sudden the interest payments exceed income (exacerbated from a falling GDP/taxrevenue). Spirals like that can happen blindingly fast. Defaults kill reserves and debtors lose the ability to get necessary emergency funds, currencies crash and are not longer cash

Gotta look at the big picture…don’t risk your capitol, a massive bet for a few more points….thats how this whole mess started to un ravel…and it ain’t over yet

http://www.investingforincome.com Investing for Income

Good insights.

However, I think there are other options other than junk bonds.

I like high yielding equities that are directly or indirectly involved in the commodities sector.

Brad

John, So what can people do with this understanding to help their families now and today while we still have time? thanks

http://www.taoeconomics.com Silver

There are some pretty good companies that sell stuff that people need and pay 3 to 4 % in dividends each quarter. Hell of a lot better U.S treasuries. Yep stocks may have another leg down, but 10 to 12% in dividends a year make the blow easier, and if you are re-investing them then you end up buying the stock when it’s cheaper as well.

Brad Thrasher

JR asks, “What happens to retirees when their savings and pension funds are vaporized by the inevitable junk bond bust?”

My father’s solution is the honest one. Die broke. He told me he is spending down his savings because the interest isn’t enough to live on. Me, I’m 52 and will never retire. I knew this when I was still a child. There are simply too many people in my age group for the Social Security Ponzi Scheme to work.
As long as I’m healthy enough to work that should be enough. Most people don’t like manual labor so if I can just make myself useful somewhere I should be able to get by. I can’t take anything with me when I die anyway.

Lee

Wow. The artical thoughtfully included in the comments by Brad on Japanese “Elder Crime” is VERY interesting. If oldsters here face a “Nothing To Loose” life, We could see more of this here; I predict particularly when it comes to Drug Manufacture, sales and Distribution. If the US ends up with Economic Conditions similar to Japans beginning now and Extending out 10 years–as a society, we could have a mess on Our hands.

Living The High Life

Just marry someone with money. It is easier than you think.

Danny B.

John you are the man! Great timming on the article regarding shorting the for-profit schools…those stocks have been hammered over the past week since your article…Thank you and great work as usual.

Bruce C.

It’s true! You can marry more money in 15 minutes than you can make in a lifetime.

And, yes, I heard about the stock price drops of some of the for-profit schools too. I didn’t short them though because I just didn’t feel like doing the due diligence. I’m happy enough with my general inverse ETFs.

I, too, had to laugh when I read that the high-yield bond issuers have low default rates. Maybe the FED should buy those bonds instead of Treasuries to get a better yield. I like that some of those companies are selling bonds to pay “special dividends” to their private-equity owners. Why do I doubt that those owners are the one’s providing the financing? After all, the default rates are so low!

There is definitely a growing need for financial products that to produce yield. It reminds me of the sub-prime machination in which the investor demand for mortgage securities pressured the industry to write mortgages of increasingly dubious quality. This time it’s different though, because the ratings agencies are under more scrutiny so when they say a bond is “junk” they really mean it.

Funny, with gold going up about 10% a year, why isn’t the WSJ recommending gold for high yield? I have made about 30% in 2 1/2 years…

Also, physical gold cannot default, unlike a high-risk bond issuer.

Steve

Yes, but it’s that 16% RT premium for gold…

S

http://goldsilver.com/silver/ref/970 Chuck Madere

Chuck Madere Here:

You have written a very good article and have hit the nail on the head with the content. Yes people are worried about their money and are running this way and that trying to make it continue to come in.

There is just one problem I see them making.

The are using the same companies that have led them to the problem. They need to stop and stick their heads up and take a real long look around and then step out of the box they are in.

I was talking with a friend the other day and he was telling me that his banks gives him 1.25% interest on his money he keeps in his savings account. I said you have to be kidding me. 1.25% is next to nothing. He agreed and asked me what I do.

Here is what I told him:

First of all never put anything of value in a bank. Don’t open a savings account to store your money. Put it to work for you just like the bank does.

Second. Do not get a safety deposit box to put things in that you want to keep private. If the banks go belly up like they were doing not so long ago, you will loose everything you have in it to the banks.

Third. I told him that I would give him 7% on his money and I use it to buy real gold and silver for myself. He laughed at me and said, are you serious? I said I sure am. You see I have been making a pretty good living for myself by buying real gold and silver and storing it in my own vault that is in a secret place.

There is good money to be made with precious metals and the best part is that when the dollar becomes history my money is safely tucked away and ready for me to use. I live off the increase and keep the principal.

This friend of mine has yet to make up his mind as he like most people think that our government will take care of this problem for us someday. Too bad I say. The government was responsible for getting us in this mess and I don’t see them caring enough about us to make a change.

So here it is. Go out and buy Silver primary and then Gold. Silver is out performing gold by leaps and bounds right now and it looks better everyday.
I use my silver to buy my gold. You all should do the same because it will not get any better for a long long time.

John Rubino is an analyst and investment advisor with Bearing Asset Management, 208-874-8010, which strives to both protect clients from the coming financial crisis and position them for the opportunities that will be available at the bottom.